The Bitcoin Bubble

There is one overriding issue with the Bitcoin and crypto subject: emotions. People are either “pro crypto”, saying it will change the world, that it is a revolutionary technology that changes everything and adds massive value to society, that it frees us from the excessive power of banks and on and on. Then you have the “anti crypto” group, saying it is a fraud, a lie, a bubble without reason, that it has no value, that it is dangerous due to lack of regulation, and on and on.

Everybody chill.

Lets take a step back and look at it from a purely monetary angle, with cold logic and deductive reasoning, using data and reasonable assumptions, and see what we get.

First, the price… a picture is worth a thousand words. Here is the price for 2011–2017: from less than 1 usd to 10 500 usd, a stratospheric return:

Note that it started at about 1 cent back in 2010. Is it a bubble? It sure looks like one! If it is, at what price will it pop: 15 000$? 20 000$? 50 000$? 100 000$? A million? … and what event/trigger might make it pop? I don’t know… do you? Read on…

I will NOT talk about the difference between blockchain technology and cryptocurrencies like btc (Bitcoin), as this has been discussed at length and has become cliché to the point of exhaustion. “Serious and responsible” economists and market analysts keep replaying the same tune that “Bitcoin is a bubble, but blockchain has a future.” We get it: at the height of your wisdom and deep insights, that’s what you came up with…

We all know there is considerable value and potential applications in the underlying technology supporting Bitcoin, Ether, and many others. Now we need to understand the dynamics of the price of those cryptos to remove the emotions and reason with deduction.

Is it useful?

Bitcoin has no “actual usefulness” for now and is not likely to gain much transactional use due to transaction scalability problems. There are anecdotal examples of transactions, but it’s very limited. Just try to spend a year paying directly with btc (bitcoins) for your expenses and you will see how useless it is for transactions. Btc has no uses per se: not used to pay salaries, to write debt contracts, to pay for stuff (other than rare cases), etc. Plus, nobody in their right mind would take a debt denominated in btc, because the equivalent in usd would be rising without bound and create a crushing debt load, typical of debts taken in a foreign currency when your income is in a depreciating currency (usd and all others are depreciating versus btc).

BUT…

We could say the very same thing about gold.

Gold is of no use for actual day-to-day transactions, probably even less than btc, yet it has massive value. The actual uses of gold are rare, mostly jewelry and technology on a limited scale. Gold is the most overpriced asset there is relative to its actual usefulness when you really think about it. Yet, it has had an incredible appeal for millennia. Why?

Gold has the following characteristics:

1. It has limited supply.
2. It is used for a few things that have actual “value of usage” (jewls, etc.).
3. It does not tarnish, degrade, or react chemically.
4. It is valued because everyone thinks it has value as a social norm.

The first 2 are not that special. Palladium, silver, and a few others have those properties. Silver is also quite stable (point 3). Yet strangely, for no logical reason, gold has always been THE precious metal. It evolved like that due to a combo of historical developments and its specific characteristics and visual appeal. People started adoring gold, then others started thinking it had great value because others thought it had value, then it was used as an “anchor” for monetary value and gained status of store of value as a social norm.

An article in BBC explains the phenomenon:

“… We can rule out lead and copper on the same basis. Both are liable to corrosion. Societies have made both into money but the currencies did not last, literally.

So, what’s left?

Of the 118 elements we are now down to just eight contenders: platinum, palladium, rhodium, iridium, osmium and ruthenium, along with the old familiars, gold and silver.

…With all the noble metals except silver and gold, you have the opposite problem. They are so rare that you would have to cast some very tiny coins, which you might easily lose.

They are also very hard to extract. The melting point of platinum is 1,768C.

That leaves just two elements — silver and gold.”

Bitcoin and the Quest for a Store of Value

When you really start to think hard about stores of value, you realize they are very hard to find. Housing, art, land, gold, silver, low inflation currencies such as the Swiss Franc or the Japanese Yen. Only gold is 1) no hassle, 2) has no risk of losing value due to a spike of supply or sudden mega drop of demand, 3) does not deteriorate.

Bitcoin is not gold, because you can’t wear it on your neck or ears or wrist, it’s not “beautiful” and it has no real-world use, but it does seem to have long run potential for actual real world use (that is more the underlying technology, blockchain) AND for some reason that for now seems irrational, the general “opinion” is that this thing called Bitcoin is a good store of value, perhaps because the underlying technology HAS very real and massive economic value and the supply of btc is limited to 21 million in circulation.

Since crypto currencies are probably there to stay and others like Ethereum and Ripple have more “real world use” potential AND since btc is the “standard” (base currency) for all cryptos (like usd is for currencies), btc is positioned to be the central pillar (the “gold” or “usd”) of the rising crypto currencies and blockchain technologies, of which many have significant long run real world potential value.

It is possible that the future will be filled with crypto technology just like Internet rose to widespread use starting in the 1990s, and if such is the case, the central pillar of all this, the “gold standard”, the one thing providing liquidity and convertibility between all the parts would be Bitcoin. IF such becomes the case, btc is NOT just some bubble without legs, because if such is the case, btc is destined to become the new pillar of a huge edifice of crypto economics.

I will NOT delve into the details of the “supply process” of btc called “mining” because it is not the goal of this post. The objective here is to make sense of the price (value) of btc.

So you have limited supply, perceived economic value, anonymity, and a disconnection from central banks and governments. All this seems to have brought a lot of interest to btc as a store of value, which then started a price increase, which then caused others to notice and become curious and “jump in”, causing extra interest and price increases… Classic bubble dynamics.

Unlike credit bubbles or housing bubbles or asset bubbles or tulip bubbles, this thing called btc is not subject to a sudden spike of interest rates that puts downward pressure on typical asset prices or a realization that demand is disconnected from reality by huge orders of magnitude or by a sudden lack of the need for a store of value.

One obvious risk for btc is that governments start waging war on it for some reason. For example because criminals can park their money in btc anonymously, then sell off their btc against usd as they need real money.

Another risk is a massive selloff by initial holders of btc that want to cash their money. Indeed, if you invested 10 000$ in btc in 2011, you now have a fortune of 100 million dollars and you might want to access those dollars to pay for real stuff.

Up to now, ALL selloff dynamics that make the price drop rapidly meet new demand, thus creating “support” for the price of btc. The price of btc is incredibly resilient to selloffs.

This phenomenon has reinforced the belief that btc is a true and authentic store of value, since it can’t seem to drop a lot and is the central pillar of a rising tide of crypto currencies and blockchain technology. In turn, this adds to the attractiveness of this asset as a store of value, which adds global demand to it and reinforces the social norm for btc as a store of value. There is an emerging “Nash equilibrium” for btc as a store of value and the central pillar of crypto currencies in general.

The other thing that must be understood is that btc is essentially unstoppable by governments, because it is decentralized and anonymous, which means you can make it illegal all you want, all you will create is a black market for btc.

When you delve into the technical details of crypto currencies like Bitcoin or Ethereum or Ripple, and you ponder the potential extent of this nascent technology, you realize the genius that is behind this innovation. I have a background in pure math and programmed professionally for several years before then studying advanced economics and finance and trading, so I fully appreciate the power of the combo that crypto technology brings to the table.

What is so special about btc and other crypto currencies? In a nutshell: you can’t “copy-paste” them. This is a very new technological development, because the problem of double spending has been THE issue stopping cryptos from emerging for ages. That problem was solved shortly after 2008, and that is indeed a major historical event for those who understand money and technology… and for the world as a whole…

Money and its Value

Lets state the obvious: money has 3 specific characteristics:

1. Store of value: you can park your savings in it and the purchasing power of those savings will not erode over time, if that money is associated to a credible central bank.
2. Unit of account: you can use it to compare prices of different things and to standardize pricing in markets, like bananas cost 1$ per kilo and so on, instead of 1 banana costs 10 strawberries or 100 blueberries, etc.
3. Medium of exchange: you can buy and sell goods and services with it, instead of exchanging goods and services against other goods and services (I write this post for you and you cook dinner for me).

Why do you accept to be paid with a direct deposit in your domestic currency? After all, this is just numbers on a screen! Stop here and ponder this. Why does money that is either just paper bills with drawings OR (even “worse”) just numbers on screens have any value at all?

One word: trust.

You accept to be paid in usd or eur or cad or whatever because you “know” that this thing (papers or numbers on the screen of your account balance) will be accepted by others to pay your rent, your coffee shop, your retail store for your furniture and groceries, your school for tuition fees, and so on… and why do THEY accept this payment method? Because THEY trust that this thing called money in the form of paper or in the form of numbers on a screen will be accepted by others, and so on.

Money works as a social norm: because we all collectively believe that others will accept it as a payment for valued goods and services.

Where Does This Magical “Trust” Come From?

1. The State.
2. The payment system, associated to bomb-proof record keeping.

Did you ever wonder what happens when you pay with your debit card for your restaurant meal that costs 100$? If you and the restaurant are with the same bank, it is just a change of numbers on your respective accounts. If you are with different banks, it causes an interbank payment: your bank pays the restaurant’s bank.

In all cases of transactions, we literally blindly trust the record-keeping of who has what account balance and why, and this blind trust is supported by reality: the payments system and the record keeping of account balances via the standard banking system is unbelievably solid and flawless. In fact, it works SO well that we don’t even think about it! It’s like your heart or other organs: you don’t think about that super complex “system”, it just works.

Now I will NOT delve into the deep insights of money, institutions, trust, the banking system, and the interbank market, but I will say this: we all trust this system because it works incredibly well. ALL payments are processed, the quantity of transactions per second that the official payments system can handle flawlessly is mind boggling, and the money we hold does NOT lose much value over time, because inflation is relatively low, which means that the 100$ cash you have in your pocket will be able to buy roughly the same “basket” for many years… This control of inflation is the responsibility of the central bank (Fed, ECB, BOE, Bank of Canada, etc.). You accept to be paid in dollars because you trust that those dollars will keep their purchasing power for a reasonable period of time.

Bitcoin does NOT have a scalable payments system, because transactions in bitcoin are VEEEERY slow to confirm (approx 10 minutes!), as is the case for gold, which has even LESS of a payments system — there is NONE at all. Bitcoins are also expensive to “produce” through the “mining” system typical of blockchain technology.

Bitcoin and gold are NOT money systems for transactional purposes. They are stores of value. But btc and other cryptos DO have a bomb proof system that rivals the account-keeping “trustability” of the banking system : the decentralized public ledger on the blockchain, which I don’t want to explain here, so please just trust me on this: transactions on the Bitcoin blockchain and Ethereum blockchain and others are trustable without central government backing or regulation.

Two other problems that btc had for a long time are:

1. Limited convertibility to other currencies, and mainly to usd (because ultimately if you can convert to usd, you can convert to other currencies like eur, gbp, jpy, cad, etc.).
2. Non-adoption by big institutional players.

These 2 problems are going away fast: btc is more and more widely convertible to usd AND is being recognized by large players, including a futures market with very important market players.

You have a thing that has trustable record-keeping capacity, that stores value, has limited supply, has an underlying technology that has value (blockchain), can be changed into other currencies more and more, is more and more recognized by large players of the market, can’t be stopped by governments, is considered the central currency of the rising world of crypto transactional technology which is here to stay, and has grown to be recognized as having “value-keeping” characteristics.

This is BIG.

Now maybe it is in bubble, but those that brush this off as a fad that is all hype and has no value have not put enough thought into this OR don’t understand money or technology enough OR feel threatened by it for some reason. There is power and influence in Bitcoin and blockchain. More than most people realize.

What is the Value of BTC?

When you teach monetary theory or international finance as I have many times and still do today, one thing you teach in class is that the general long run value of a currency is related to 2 things and expectations about the future of these 2 things:

1. Relative supply.
2. Relative demand.

If a currency is printed/created at a faster pace than others, it will tend to lose value relative to others (depreciate). If a currency is printed/created at a slower pace than others, it will gain value relative to others (appreciate). This is a no brainer: scarce stuff is more valuable than stuff you can find at every corner shop. Another thing that is special about btc is that no central bank can influence the value. For example, Switzerland and Japan “supply” LOTS of their own currencies (chf and jpy) in the foreign exchange market because they are trying to stop them from appreciating, which would happen if they stopped intervening constantly. This is NOT the case of btc: the price of btc is pure market forces, and that is rare.

A currency is created at a positive pace via credit creation that is indirectly influenced by the central bank, as I explained in past posts. Most currencies in industrialized countries have a positive growth rate in terms of supply.

Bitcoins have a maximum supply of 21 million. This favours btc relative to other currencies, if you think btc is a legitimate new store of value. The limited supply could be a problem, as it is with precious metals, but btc can be “cut” into infinitely smaller pieces (contrary to metals) because it is digital, so you can own 0,001 btc, for example.

The relative supply aspect is easy to analyze, so we will start with that part, before we discuss the relative demand, which is much more complex…

Taking current and expected future positive growth rates of usd supply, you have expected money supply growth of usd and expected future zero growth of btc. This expectations is priced in now and causes btc to gain value now, because speculation about future value causes speculators to buy btc now while btc is still “low-priced” to profit from the long run value advantage of btc due to limited supply and rising status as store of value.

Lets look at various levels of money in 20 years from now, supposing money supply increases at the same rate as the past 20 years, which is roughly 6% for M1 or M2 (classic measures of money supply)… In 20 years from now, we have M1 = 11 545 billion (roughly 11,5 trillion).

Based on this and supposing btc is a legitimate store of value and that the future is priced in, we have a price of btc of 11 545 000 000 000 / 21 000 000 = 549 761$, so about half a million usd per btc. Using M2 makes the price of btc much bigger, by orders of magnitude. Based on this, btc at 12 000 usd is the bargain of a lifetime!

But that’s relative supply. How about demand? After all, if something is not in demand, supply doesn’t matter, because value ultimately derives from the fact that people value something, regardless of what it is or why they value it.

Demand is significantly more complex. If it was only for supply, I would say that btc is massively underpriced at 12k usd or 50k usd. But demand changes things a lot.

How much wealth parked in OTHER assets wants to transfer to btc? The transfer is more net current demand FROM other assets (mostly denominated in usd) TO btc, so it is all new demand for btc, since btc started existing just recently.

Here you have 2 levels of demand: criminal money seeking to park massive amounts of wealth outside the official (state-regulated and supervised) banking system and 2) the rest of the world who believes that btc is a new legitimate store of value like gold because of the rising value, the limited supply, the underlying technology, the growing convertibility, and the growing adoption by large institutional players.

Total annual drug trade is estimated at roughly 400 billion. Add to this all other illegal activity and I am guessing you have something around 1000 billion annually, or 1 trillion. Total accumulated drug wealth worldwide is of course several orders of magnitude more than this, because a portion of past income was saved and parked into assets, which is a problem when you want to deposit super large sums and not raise State suspicion.

A very conservative estimate for drug wealth could be reached with the typical US wealth-to-GDP ratio of 4, which would put a lower bound on illegal wealth at about 4 trillion usd worldwide. Since illegal money is probably more likely to want to park in btc than other sources of savings, we can assume that 10% of global “illegal wealth” wants to ultimately park in btc, which would put the price of 1 btc at 0,1*4 trillion/21 million = 19 000 usd.

Now adding demand for a store of value such as gold, silver, art, land, or low-inflation currencies, we get very large numbers. Indeed, perhaps 10% of illegal money will want to park in btc, but maybe a small fraction of other forms of wealth will also want to park in btc going forward. So we need to enlarge the picture to more asset classes.

To make things simple, lets start with the total value of these 4 markets:

1. Gold = 8 trillion (8000 billion).
2. Stocks = 73 trillion (73 000 billion).
3. Bonds = 100 trillion (100 000 billion).
4. Real estate = 220 trillion (220 000 billion).

Lets NOT count real estate, to get a conservative estimate.

So the total of estimated drug wealth + gold + stocks + bonds is 185 trillion.

1. If 0.001% of this parks in btc, btc = 0.00001*185 trillion/21 million = 88 usd per btc.
2. If 0.01% of this parks in btc, btc = 0.0001*185 trillion/21 million = 880 usd per btc.
3. If 0.1% of this parks in btc, btc = 0.001*185 trillion/21 million = 8800 usd per btc.
4. If 1% of this parks in btc, btc = 0.01*185 trillion/21 million = 88 000 usd per btc.

We got about half a million usd per btc with the supply analysis and we get various numbers with the demand analysis, ranging from 88$ to 88 000$.

Supposing 1% of global wealth wants to park in btc AND that btc builds a social norm as a legitimate store of value due to its various characteristics, we get a conservative estimate for the long run price of btc around 88 000 usd per btc and an “upper bound” around half a million per btc. Adding speculation to this picture obviously adds upward pressure on the value, at least in the short and medium run. So based on this, a reasonable lower bound for the long run price of btc would be roughly around 100k usd, and that is putting only 1% of global wealth in btc.

I have a lot of difficulty believing this myself, so I would tend to brush off my OWN analysis and say it is not realistic, but if I leave my beliefs and opinions and “common sense reflex” aside, I indeed see a lower bound for btc at incredibly high valuations…

But then again, why are some paintings worth 100 million? OK they are beautiful and represent incredible genius and talent, but when you boil it down to usefulness and social value, it makes NO sense at all that a piece of art that you hang on a wall and serves no “use” is worth so much. It has massive value because there is limited supply and someone sees value in it. Period.

In the end, the value of btc will be determined by what the masses judge it to be. Seeing price drops find massive demand at 10 000 usd, it seems that the market sees its long run value at a number significantly more than 10 000$… will it be 88k or 500k? I don’t know, but we will one day find out.

It’s a wild guess, but I am not that sure the market is totally irrational about the value of btc. Obviously there IS a lot of speculation and irrationality and a lot of clueless people in this market, but that doesn’t mean there is no “macro intelligence” in the “crypto bubble” that is beyond the hype and mania of the masses.

The Risk

The risk on btc is a sudden loss of trust in btc as a “modern gold” caused by hackings and widespread fraud OR a general “war on cryptos” by states in large countries. That would drop demand tremendously. Crypto technology as a whole could also prove useless and just a lot of hype, which would mean btc is the central pillar of lots of nothing.

But for now, these risks seem limited and the upward momentum just keeps on giving… we will see where this goes, but I am not THAT sure it’s “just another bubble”, even if it sure looks like one when you look at the price chart… Pompous economists playing the wisdom card should delve into the details of this world and really think hard about it instead of just saying it must be stopped and made illegal. Perhaps you don’t “get it”, Joe. Or maybe you do, in which case the crash of btc will bring the price to zero, and we will know. But these free declarations by paternalistic economists who don’t bother to ponder this new crypto thing also seems like a bubble to me... Show appreciation by “clapping”, liking, commenting, and sharing. I hope this added deeper insights to the Bitcoin debate than the typical post with clichés and sound bites. Thanks for reading to the end.

Read Part II

Pascal Bedard

pbedard@yourpersonaleconomist.com